I work for an oil trading company. We sell petroleum products indexed on the Brent and hedge our fixed price sales using futures to offset price fluctuations. We do not engage in speculation. I was wondering if there was any advantage to engaging in delta hedging (or delta-gamma hedging) with oil options? I could not think of any, as futures hedges are close to perfect hedges, except for the fact that delivery periods do coincide with the months of futures contracts. However there are other ways to manage this time mismatch.
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1$\begingroup$ In the OTC space, you might enter bespoke options/forwards positions, effectively cutting all risks from time,size mismatches - at the price of either counterparty credit risk, liquidity risk (thru funding the position) or a bit of both. $\endgroup$– KermittfrogOct 10, 2022 at 7:48
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$\begingroup$ Thank you, but my question was not about the pros and cons of OTC vs exchange executed trading, but rather the pros and cons of hedging a physical commodity position with futures (eg. long physical, short paper), versus with options (eg. long physical, short option with the right delta ratio) $\endgroup$– Michael GrossmannOct 11, 2022 at 12:42
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$\begingroup$ I understand. With options, you can add a "view" to your position. If you are betting on increasing (decreasing) prices, you can lock-in some form of profit. $\endgroup$– KermittfrogOct 11, 2022 at 14:43
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$\begingroup$ Out of curiosity, what is the "right delta ratio"? One obvious benefit of options vs futures is the non linearity of options. When you write a "future close to perfect hedge" it mainly means in my opinion that you know your price. With options, you only face one side of the market and if the market moves in your favour, you get the benefit. I am not sure how delta hedging should help you though. $\endgroup$– AKdemyOct 11, 2022 at 18:29
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1$\begingroup$ If you sell petroleum products, swaps may be useful because you can mimic the physical flow. It may also be worth to look at Asian Options (Average rate options), where the underlying price or the strike is determined based on the arithmetic or geometric average of the underlying at multiple sampling periods. These are important in commodities because they usually better align with the hedging needs and are similarly structured to swaps. They are also almost always cheaper than their vanilla counterparts because of the averaging feature which inherently leads to less volatility in the option. $\endgroup$– AKdemyOct 11, 2022 at 18:31
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1 Answer
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Assuming all other things being equal:
If you are long the commodity, and short the future, then your risk is zero.
If you are long the commodity, and sell a call, then you will earn the option premium, but risk the value of the commodity going down. In other words, you won't hedge against downside risk, but will trade upside risk for a guaranteed premium.
If you are long the commodity, and buy a put, then you will pay the option premium, and will be protected if the commodity goes down. However, if the commodity goes up, you'll earn less, because you had to pay for the premium.
Drawing some options payout diagrams can aid understanding on these topics.
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1$\begingroup$ In theory, if one ignores the transaction costs, if one is long the commodity, one can buy a put at the money and sell a call at the money and be hedged. The premium of the sold option compensates the premium of the bought one. However, the transaction cost of this strategy is probably higher than just shorting a future. $\endgroup$ Oct 15, 2022 at 12:41